We expect that US economic expansion will continue in 2026, driven by a combination of fiscal policy designed to boost the economy and a likely dovish Fed. The One Big Beautiful Bill Act (OBBB) was designed to deliver fiscal stimulus heading into a midterm-election year by expanding tax deductions, credits, and refunds in the range of $150 billion. Some of the changes took effect in July when the bill was passed and should result in tax refunds as early as this spring. Others will take place throughout 2026 as paycheck withholding tables adjust and take-home pay for many workers may increase.

Corporate tax incentives, which were retroactive to January 2025, include 100% expensing of capital equipment purchases and domestic research and development costs, higher interest deductions, and immediate expensing of the cost of building production and manufacturing facilities.  The corporate incentives in the bill are estimated to have provided more than $100 billion of stimulus in 2025 with another $135 billion expected for 2026.

At the same time, enacting the tax bill was a clear indication that any focus on deficit reduction is off the table for now. In fact, the OBBB is expected to increase the deficit by more than $3 trillion over the next 7 years, plus an additional $441 billion in interest costs.

Consumer Health and Sentiment: The K-Shaped Reality Deepens

There remains an increasingly uneven profile of US economic growth, characterized by a K-shaped structure, a trend that will be further skewed by many of the tax benefits in the OBBB. Higher-income households, supported by equity market gains and accumulated wealth, continue to account for a disproportionate share of overall spending, which is the biggest driver of US economic growth.  At this stage of the cycle, equity markets are increasingly becoming a significant driver of consumer behavior, rather than merely a reflection of economic conditions. As a result, market performance has a more direct influence on confidence and discretionary spending, than in prior cycles. As of fiscal year 2024, roughly 50% of government revenue came from individual income taxes.  It is easy to see how a significant market decline would not only affect economic growth but also put pressure on tax receipts needed to fund government spending without relying on further debt issuance.

Lower-income households face a very different reality. Rising debt balances, higher delinquency rates, and declining real wages continue to pressure budgets for a group that often lives paycheck to paycheck, leaving little margin for error should labor market conditions weaken further. Taken together, these dynamics suggest a consumer environment that remains supportive of growth but is more fragile and sensitive to market and policy shocks.

Stock Market Ownership
Proportion of Household Assets Invested in Equities

Recessions are indicated by the shaded area.
Federal Reserve, Financial Accounts (Flow of Funds) – Z.1
Households & Nonprofit Organizations, Directly & Indirectly Held Corporate Equities
Quarterly data available from 1945 Q4 to 2025 Q2, last released on Thursday, September 11, 2025

Share of Spending by Consumers in Top 10% of Income Distribution
High-income Americans are behind roughly half of all US consumer spending, up from about a third in the early 1990s

Source Bloomberg News Release (Moody’s Analytics review of Federal Reserve Data)
Data: Quarterly from 1989 Q4 – 2025 Q2

A Resilient but Increasingly Uneven Expansion

While headline GDP remained positive during the quarter, macroeconomic signals were mixed and at times contradictory. Consumer spending has been steady throughout the holiday period, although increasingly bifurcated between high- and low-income households. Real (inflation-adjusted) wage growth deteriorated, suggesting that even steady nominal wage increases leave workers struggling to keep pace with inflation.

Businesses also entered a more uncertain phase. Top-line growth remained positive, aided by ongoing productivity improvements, many of which were tied to AI adoption; however, multiple indicators reflect a loss of momentum beneath the surface. On the one hand, firms continue to invest in AI-related infrastructure to avoid being left behind, resulting in significant capital expenditures. On the other hand, questions about the sustainability and concentration of this spending, particularly the market’s heavy reliance of a select few companies, raise concerns that aggregate capital expenditures will soften as companies reassess the pace of AI buildout. These dynamics mirror the broader market rotation observed during the quarter, as investors shifted away from the narrow group that drove returns earlier in the year.

Manufacturing activity contracted for much of the quarter, and business confidence wavered amid shifting tariff policies and uncertainty surrounding the government shutdown.

The shutdown created large blind spots in federal data releases, complicating real-time economic assessments and heightening market sensitivity. With incomplete labor statistics, inflation readings, and household data, investors and policymakers were forced to rely more heavily on private surveys and anecdotal indicators. This heightened the sense of opacity in an economy already showing signs of divergence.

Labor Market Cooling Beneath the Surface

The labor market remains at a key point of transition. Despite low headline unemployment, several underlying indicators weakened throughout the quarter. Continued jobless claims increased, and layoff announcements became more frequent. Hiring slowed noticeably across small businesses, which not only employ nearly half of the US private-sector workforce but also represent the business segment most exposed to higher borrowing costs and tighter credit conditions.

Unemployment rose to a four-year high late in the year, making it increasingly clear that the labor market is cooling. Meanwhile, an elevated youth unemployment rate and fewer employees switching jobs are additional signs of labor-market weakness.

AI-driven productivity gains are real and potentially transformative, but history suggests that economy-wide benefits tend to lag initial adoption. In the current cycle, job displacement may precede job creation, introducing transitional labor market stress even as long-term productivity improves. This timing mismatch carries economic and political implications, reinforcing uncertainty around employment, income growth, and policy responses during the next phase of the expansion. These developments matter not just for employment itself, but also for the economy as a whole.

Challenger Job Layoffs and Hires
January to December 2025

Policy Crosscurrents: Tariff Volatility, Fiscal Instability, and a Changing Fed

Economic conditions were further complicated by ongoing trade policy volatility, including shifting tariff proposals, limited truce periods, and renewed restrictions on strategic materials. These dynamics directly impacted inventory planning and input costs, particularly for manufacturers. At the same time, political gridlock and the government shutdown contributed to fiscal uncertainty, with implications for both consumer confidence and market liquidity.

Monetary policy also remained in flux. The Fed implemented two 25-basis-point cuts during the quarter but signaled a cautious stance given incomplete data and differing views about the proper degree of economic cooling. In addition, upcoming leadership changes at the Fed have raised concerns about its independence and the importance of maintaining its credibility with global investors in managing long-term inflation expectations, potentially affecting interest rates in 2026.

Why Growth Has Persisted – For Now

Despite growing signs of strain beneath the surface, economic growth has remained resilient. One crucial factor is the political and policy backdrop. As the US enters an election year, fiscal and regulatory incentives tend to promote economic growth rather than restraint. Policymakers across the spectrum are incentivized to sustain employment, confidence, and market stability, which contributes to a bias toward continued growth even as longer-term imbalances accumulate.

At the same time, fiscal measures, ranging from targeted tax incentives to investment-related subsidies, have helped offset the lagged effects of higher interest rates. These policies do not eliminate longer-term structural risks related to deficit growth, debt financing costs, and inflation, but merely push them into the future. This dynamic reinforces our view that the current expansion remains intact, though increasingly dependent on policy support and confidence rather than broad-based economic momentum.

Global Forces: Geopolitical Risk, Domestic Outcomes

Overlaying these domestic dynamics is heightened geopolitical risk. Ongoing conflicts, rising protectionism, shifting trade alliances, and the potential for escalation in multiple global flashpoints introduce additional uncertainty. Geopolitical shocks can disrupt supply chains, reprice energy and commodity markets, and rapidly alter inflation and interest rate expectations.

Additionally, the US dollar has weakened over the past year amid a lack of confidence in US fiscal discipline, uncertainty over trade policies, and geopolitical tensions. While a weaker dollar can enhance US export competitiveness and support earnings for US multinationals, we are a nation of importers, and dollar weakness raises import costs and inflation.

A lower dollar may also reduce foreign demand for US assets, thereby increasing longer-term debt-financing pressures. The US government relies heavily on foreign capital to buy US Treasuries. This additional international demand allows the US to finance its debt at a lower rate than it otherwise would.

Entering 2026: A Delicate Balance

The US economy enters 2026 with a unique mix of headwinds and tailwinds. Fiscal stimulus from the OBBB will inject additional momentum through expanded tax refunds, higher take-home pay, and corporate incentives that encourage investment. At the same time, monetary policy has shifted to easing, with lower interest rates and renewed liquidity support following the Fed’s pivot from quantitative tightening. These forces, combined with the political backdrop of a midterm election year, create conditions for an economy that is likely to “run hot” in the near term.

However, growth will increasingly be policy-dependent, and the interplay among fiscal expansion, accommodative monetary policy, and elevated debt levels may exacerbate longer-term economic risks that are merely being pushed further out. Inflation expectations, employment, and geopolitics remain critical variables that could challenge stability. In short, while 2026 begins with strong momentum, the balance between stimulus-driven growth and structural fragility will define the year ahead.

The Equity Market

A Favorable Market Environment

Equity investors enjoyed another year of solid returns in 2025. The S&P 500 and other major indices overcame a dramatic April selloff following the “Liberation Day” tariff announcement and other periodic pullbacks to finish the year near record highs. Analysts currently anticipate double-digit earnings growth in 2026, aided by improving profit margins in sectors that had faced cost pressures. Cooling input-cost inflation (from commodities to wages) and productivity enhancements from new technology investments have begun to support margin recovery for many businesses. These positive fundamentals, combined with fiscal stimulus and the Fed’s shift to lower interest rates, should benefit equities in 2026, helping offset some valuation concerns.

Importantly, market breadth improved as the year progressed. Early in 2025, gains were heavily concentrated in a few mega-cap technology and AI-centric companies. By the fourth quarter, however, the rally had broadened to encompass a wider swath of industries and market-cap tiers, as more companies delivered profit beats and issued upbeat guidance, giving investors confidence in segments beyond the initial tech leaders. Even small- and mid-cap stocks staged a comeback in Q4. Smaller companies tend to benefit disproportionately from a lower interest rate environment, and Fed easing helped alleviate one of the key drags on small-cap valuations. We also note that international equities participated in the upswing, outperforming US stocks while still trading at valuation discounts, partly due to stabilizing global growth and partly to the relative weakness of the US dollar.

Market internals confirm this healthier breadth. The share of total S&P 500 earnings generated outside of the top handful of companies has begun to rise, reflecting profit growth that was no longer exclusively a mega-cap story. We view this development as a healthy evolution. A market supported by many legs is inherently more robust than one balancing on just a few giant companies. It is also encouraging that cyclical areas, such as transportation and semiconductors, and interest-rate-sensitive groups, such as housing-related stocks, showed strength. This pattern has historically preceded durable economic expansions.

S&P 500 Price Returns
S&P Tech Sector vs S&P ex Tech Sector